Bank of England urged to let wages catch up before raising interest rates

EY Item Club is calling for Bank policymakers to include 'positive growth in real wages' in their forward guidance policy

The Bank of England has been urged to 'to urgently supplement the forward guidance threshold to include positive growth in real wages alongside a lower threshold for unemployment'. Photograph: Luke Macgregor/REUTERS

Monday 20 January 2014 03.44 EST
First published on Monday 20 January 2014 03.44 EST

Interest rates should be kept on hold until squeezed real-term wages finally begin to grow to avoid choking off the fragile recovery, according to a leading economic forecasting group.

The EY Item Club report calls for Bank of England policymakers to bolster their forward guidance policy which pledges not to consider lifting the rate from 0.5% until unemployment has fallen to 7%.

The forecast says this threshold is now expected to be met in the first half of this year, two years earlier than first expected.

However, wages remain subdued, growing at half the rate of inflation – although this has slowed recently to 2% – and the report calls for consideration of this factor to be added to the Bank's policy pledge.

Slow wages growth means they are falling in real terms and represent what the report says is an "Achilles heel" for the coalition - which is under pressure over what Labour calls a "cost of living crisis".

The Item Club report predicts UK economic growth will surge to 2.7% in 2014 but that wages will only grow by 1.8% this year, before slowly picking up to 2.7% in 2015 and 3.5% in 2016.

It calls for the Bank's monetary policy committee (MPC) "to urgently supplement the forward guidance threshold to include positive growth in real wages alongside a lower threshold for unemployment".

The report says: "Raising interest rates too soon, before real wages have also begun to improve, could risk choking off the fragile consumer led recovery."

It also warns that the "lop-sided recovery", which has been led so far by consumer spending, must be rebalanced through business and investment before a rate rise is considered. Consumer spending cannot continue to fuel growth while real wages remain under pressure, it adds.

The report forecasts the first rate hike in autumn 2015 "when conditions for a broader recovery should be satisfied".

Peter Spencer, chief economic advisor to the Item Club, said: "It is hard to find another episode in time where employment has been rising and real wages falling for any significant period of time.

"The weakness of real earnings is proving to be the government's Achilles heel, and could prove to be the weak spot in the recovery.

"Consumers have reduced the amount they save to fund their spending sprees. But they cannot continue to drive growth for much longer without an accompanying recovery in real wages or a rise in their debt to income ratio."

The sharper-than-expected falls in the key unemployment rate have already prompted market fears that the Bank rate will be raised sooner than expected.

Policymakers have stressed the 7% threshold is not an automatic trigger to raise rates and will instead simply mean a rate hike can be considered, while taking other key factors into account.

There is mounting speculation that the Bank will seek to shore up forward guidance to pledge to bolster reassurance about the path of interest rates, though there has been no official change to policy.

But in a speech last month, chief economist Spencer Dale told businesses: "You can plan for the future in the knowledge that the MPC intends to keep interest rates low until we have seen a prolonged period of strong growth, unemployment is significantly lower, real incomes are higher."

The Item Club report also forecasts that labour force growth to 2015 will be dominated by older workers – with 400,000 who would previously have retired holding on to their jobs, far outstripping the impact of other factors such as immigration.

Meanwhile, it scotches fears of a housing bubble, saying an accelerating market supported by the government's Help to Buy scheme will be kept in check by stronger supply from house building.

Spencer said: "There is little evidence of a housing bubble at present; prices are still well shy of their pre-crisis peaks in money terms and some 25% lower in real terms, while affordability and indebtedness measures are far less stressed than they were during the financial crisis.

"The stronger market has encouraged a robust pickup in house building and our forecast shows this continuing, with residential investment recovering strongly."